Consider an economy with marginal product of capital (net of depreciation) 4%. A

Question

Consider an economy with marginal product of capital (net of depreciation) 4%. Assume that banks in this economy offer interest rate of 10% on deposits. Can you tell anything about inflation rate in this economy? Assume that inflation rate is 5% and MPK is still 4%, which nominal interest rate would be offered by the banking sector? In b) assume that one bank offers deposit rate of 8%. What will happen to this bank? Why? In b) assume that now this bank offers 10% on deposits what will happen to this bank in the long-run? In d) what will happen to the banking system if the bank offering 10% is state-owned?

Explanation / Answer

a. Acc to fisher euation

i = r + inflation rate

10 = 4 +  inflation rate

So,   inflation rate = 6%

b.     i = r + inflation rate

i = 4 + 5 = 9%

S0, interest rate offered by bank is 9%

c. If the bank offers 8% on deposits , the bank will earn a profit as the bank can provide the loan at an interest rate of 9% and obtain the money from deposits to finance these loans at an interest rate of 8% .

d. If the bank offers 10% on deposits , the bank will run out of the funds or will go earn a negitive profit as the bank is providing an interest rate of 10% on deposits but the money obtained through these deposits is loaned out at an interest rate of 9%. and hence Banks will not be able to continue in the long run

e. If the Bank offering 10% is state owned then the banking system will get reduced ass the other Private Banks won't be able to provide 10% on the deposits and hence will shut down and thus the banking system will shrink.

If you don't understand anything then comment , i'ill revert back on the same.:)

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